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Monday, 18 December 2017

On CoCos, CBOs and EM woes

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  • Anthony Peters columnist format

Peters ponders the dramatic arc of structured debt, as titans clash on emerging markets.

Hot chocolate or hot CoCo? “Chapeau!” to Switzerland’s UBS for a highly successful €2,000,000,000 12-year Lower Tier II Contingent Capital bond issue yesterday. This should open more floodgates in the CoCo space.

Since the market for risk sharing subordinated bank debt first opened a couple of years back we have come a long way and CoCos are now a natural part of the market landscape and the sector must be good because it even has its own index. So far, so good.

Now for the “however” – there’s always a “however”. Do we really know what the correct price is for contingent capital? The product was created in the long shadow of the post crisis regulatory environment and not, as Bill Blain of Mint Securities pointed out some time ago, by natural investor demand.

The stuff is cheap – or at least it looks it by dint of the fact that it carries very juicy coupons but how can we establish whether it is cheap or not until we have seen what happens when the embedded risks are triggered.

As usual;, everything was fine and dandy until it started to go wrong and….whoooosh!

My own mantra is that there is no such thing as a bad credit, just a wrong price. This was brought home during the second structured credit wave. The first one was driven by CMOs in the early 90s which were supposed to sport negative convexity but which turned into a complete dog’s breakfast when rates began to rise in the post Feb 4th 1994 Fed tightening cycle. The second wave was full of CBOs which looked just like CLOs except that they used the more liquid unsecured bond market as a source of assets rather than the secured leveraged loan market. That was fine until the likes of Enron and WorldCom and Global Crossing defaulted, defying the key investment assumption that a defaulted bond would recover 30ish% of principal. These bonds, along with others, especially in the highly leveraged telecoms and healthcare spaces, were written down to nothing and with that the CBO market crashed and burned.

The third wave of credit structuring, if you want, brought us subprime RMBS, another “hot market” in which the assumptions plugged into worst case scenarios, default probability and expected recovery rates again proved to be wildly off the mark. As usual;, everything was fine and dandy until it started to go wrong and….whoooosh!

Until we have experienced the first write-down event in the CoCo market, we won’t really be able to gauge the full impact and hence be able to opine whether they were ever really correctly priced. Not only that but the 2007/2008 banking crisis showed up the high correlation of balance sheet risk across the global financial sector. When the next broad credit crunch happens – be that in two years, five years, ten years or later – it will in all likelihood again take with it the entire industry and CoCo trigger events will be upon us by the dozen.

On the whole, the 5% common equity trigger looked a bit low to some but the market didn’t seem to care – 340bp of spread on a Tier II security was and is compelling, especially as many see UBS as one of the few banks which really has taken all the hits to its capital and which subsequently has one the cleanest front and back books in the business.

Far be it from me to judge the Spanish, Italian, French or even German banks for honesty and transparency but one does get the feeling that CS and UBS are ahead of the game here and if I were to buy into the CoCo market, there is probably no better place to start.

Stick or twist? 

Meanwhile, I note that the two great gurus on matters concerning emerging markets, Mark Mobius of Franklin Templeton and Jim O’Neill, former Goldman big wig, do not agree on what to do next. The former sees the current pull-back as a buying opportunity, the latter senses that investor confidence in the sector is low and that markets hold here at best but could do another leg down before they begin to recover. On the basis that it is always better to miss the first 10% of a rally than to take the last 10% of a sell-off I’d be tempted to stick with Mark Mobius’s view.

Enter, stage left, Stanley Fischer, nominee for the Vice Chairmanship of the Federal Reserve. Whilst at the IMF in the late 1990s Fischer was a serious proponent of free floating currencies, even in developing countries. A large part of the damage during the “Asian Flu” was done by central banks blowing their reserves trying to defend overvalued currencies. A strong currency may be a nice sign of economic virility but it is not the be all and end all which it once appeared to be. The more flexible the currency, the higher the adaptability and the faster the recovery.

With that thinking accounted for, O’Neill who created the BRIC moniker has a strong point. But Mobius has been at this game for far too long and I would find it hard to invest against his advice. In other words, maybe better to hold off a bit longer.

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Alas, it is that time of the week again. All that remains is for me to wish you and yours a happy and peaceful week-end. England conceded victory in the dying minutes of their game against France in Paris last weekend and how well they played is of no further interest. France needs a bit of an uplift, not least of all in light of the pearl of wisdom which relates that proof of how poor the economy is lies in the fact most Frenchman have had to start loving their own wives again.

Might be but lucky for the President that he’s not married… 

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